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Capitalise On US Small-Cap Uptrend & Aussie Dollar Downtrend

By Tony Featherstone |17.06.2013

The debate between managed funds and exchange-traded products (ETPs) is usually pitched in black or white terms. That is, investors pay higher fees for managed funds that actively try to outperform their benchmark index, or use low-cost ETPs for passive index exposure.

ETPs proponents typically point to research showing the vast majority of active funds managers underperform their index over time, after fees, meaning investors are better off using low-cost index products. Active fund managers argue investors are giving up if they settle for the index return.

This active versus passive debate is vital for long-term investors such as Self-Managed Superannuation Funds, which greatly benefit from lower-cost investment products, and also for portfolio investors who can improve diversification and overall transaction costs through a better mix of active and passive strategies.

But the debate is disingenuous on several levels. For one thing, too many so-called active fund managers are in reality “index huggers”. Their portfolios too closely mirror the benchmark index, so as to minimise tracking error (the difference between the fund return and index return). The upshot is investors paying higher fees for a return not vastly different from a comparable ETF.

The “passive” label for ETPs, which some issuers do not like, is also misleading for several ETFs. As the ASX-listed ETP universe grows, more products will incorporate limited forms of active-management strategies, to boost returns. That has been the case overseas, with a rise in the number of ETPs that blend passive and active investing techniques. Some ETFs have gone so far with this strategy they are hard to even recognise as index products anymore.

The “passive” tag’s other problem is that ETPs can be used tactically for active exposure. For example, I have outlined strategies in The Bull in recent months that involved using ETPs to capitalise on rallies in US and Japanese equities, and a falling Australian dollar relative to the Greenback.

Another favoured trading strategy is using ETPs such as the iShares Russell 2000 (ASX Code: IRU) to capitalise on a medium-term uptrend in US small-cap equities, and the Australian dollar’s downtrend.

My point is: rather than see managed funds and ETPs as opposite products, investors must get better at combining them in portfolios to improve overall diversification and reduce fees. One of the simplest strategies is a “core and satellite” approach, where low-cost ETPs are used in the portfolio core for index or passive exposure, and funds or direct stocks are used as the “satellite” component for active exposure.

Put another way, investors can use ETPs for Beta (the market return) and shares or funds they favour to gain Alpha (a return greater than the market). Don’t be put off by the jargon: the idea of using index funds in the portfolio core is much simpler than holding 20 stocks directly.

Another option is using low-cost investment products that provide limited active exposure. Big listed investment companies (LICs) such as Australian Foundation Investment Company, Argo Investments and Milton Corporation are good examples. They provide moderate active exposure – certainly less than many managed funds that turn over portfolios more frequently – at low cost.

ETPs are also becoming an option for investors who want limited active exposure. The UBS IQ Research Preferred Australian Share Fund ETF (ASX Code: ETF) is a good example of what investors should expect. It aims to replicate the performance of the UBS Preferred Research Index before fees.

The UBS ETF provides exposure to about 40 stocks based on research from the UBS equity research team. Although the ETF provides index exposure, the index itself is more dynamic as stocks are added or dropped, based on the research team’s best ideas.

It’s a clever idea. For just 70 basis points annually, investors get exposure to a portfolio of stocks hand-picked by one of the market’s best research teams, which are added or dropped according to research ideas, rather than index re-weightings. The UBS ETF looks a good choice for long-term portfolio investors who want limited active exposure at much lower cost than traditional managed funds – and better value after falling from about $23 in March to $$20.39.

The UBS IQ ETF’s performance over three months to May 31 (net of fees) – minus 5.46 per cent – compares with a 3.5 per cent fall in the S&P ASX 200 index over this period. A higher weighting of small-cap stocks, which collectively have underperformed, in the UBS IQ ETF might explain the performance discrepancy, although it is early days given the fund was launched last October.

Over time, the concept of very low-cost index products that provide moderate active exposure to enhance returns should appeal to Australia’s army of Self-Managed Superannuation Funds. Whatever happens, expect to see a lot more shades of grey compared with the current “black and white” debate about the virtues of active versus passive funds.

Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Feb 14, 2013. The author implies no stock recommendations from the above commentary. Readers should do further research or talk to their financial adviser before acting on themes in this article.